Funding is returning slowly for hotel properties, as many lenders have learned the hard way that hotels can be tricky collateral. Commercial mortgage brokers can expect these lenders to be more cautious when reviewing hotel properties as collateral for loans, and they should prepare clients for a close look at these assets before financing is secured.

To start, brokers should understand why lenders consider hotels different than other types of commercial real estate properties. Although hotels are operating businesses, they are highly prone to extreme fluctuations in revenue and operating expenses, unlike retail, office or multifamily properties.

Commercial mortgage brokers must keep this in mind when originating a loan involving a hotel property as collateral. They also must plan and prepare their clients to respond to lenders’ concerns regarding these types of business issues, and other pitfalls unique to this type of asset. The following five problem areas likely will be addressed by lenders at loan origination in an attempt to avoid problems and losses should the loan default or the borrower become uncooperative.

1. Personal property

Hotels contain significant personal property, like furniture, restaurant equipment, etc., that should not be overlooked in the loan-origination phase. It is important to confirm who owns the personal property. If the hotel has been master-leased to a third party, the master lessee rather than the borrower may be the owner of some or all of the personal property.

It may be required that loan documents include personal property as part of the lender’s collateral, and all parties must grant the lender a first-priority security interest in the personal property. Lenders typically try to confirm that there are no existing equipment or personal-property leases or other liens affecting the personal property that could have priority over the lender’s mortgage.

Clearly used personal property is not valuable when sold in the open market, but it is essential to keep a hotel operating. Additionally, a Uniform Commercial Code (UCC) financing statement must be filed in the state of formation of the parties pledging the personal property to the lender to perfect the lender’s security interest in the personal property and to avoid any priority or bankruptcy issues.

2. Franchise agreements

For a hotel to operate under a specific brand, it must be licensed to use the signage and other marks related to the brand. The hotel owner or the operator of the hotel typically enters into a license agreement or franchise agreement with the franchisors setting forth the rights and obligations with respect to operating the hotel under the branded system.

Make sure that your client is prepared for lenders to review the franchise agreement. That is standard procedure to confirm the terms of the franchise in the event the lender forecloses and assumes the obligations under the agreement. Lenders also will want to scrutinize the following points:

If any rights of first-refusal or purchase options are granted to the franchisor, these rights should be subordinate to the rights of the lender under the mortgage.

The term of the franchise agreement should be at least as long as the term under the loan.

Whether the franchisor is giving any “key money” or loan to the hotel owner as incentive to complete certain brand-required capital improvements to the hotel. Key money is paid to the hotel owner at the time the franchise agreement is entered into and the obligation to repay the key money is typically forgiven over the course of the term of the agreement.

These types of rights and obligations can be binding on the lender in case of foreclosure and can impact the lender’s ability to sell the property post-foreclosure. That is why lenders often will try to address them upfront with the borrower and franchisor.

3. Improvements

Lenders likely will confirm that the borrower has the funds or ability to pay for any improvements required by a franchisor in connection with renovating the property to bring the hotel into compliance with current brand standards. A franchisor may set a property improvement plan (PIP) that contains a list of items to be replaced or renovated at the hotel, along with time frames for each item to be completed.

Lenders likely will request a cost estimate or renovation budget from the borrower with respect to the PIP at loan origination. They also will want to confirm that the borrower has a source of funds to pay for the renovations by requiring that the funds be either deposited into a lender-controlled account from which funds can be withdrawn by the borrower for purposes of completing the renovations, or require a letter of credit or guaranty.

Lenders also may try to confirm that there is a mechanism like a completion guaranty to incentivize the borrower to complete the work in a lien-free manner. Because of the recent economic downturn, many franchisors have not enforced deadlines and requirements with respect to needed renovations. In case of foreclosure, however, lenders often are required to complete unfinished work to maintain the franchise. Without the security of reserve funds or a guaranty, lenders will have no ability to recover these expenditures.

4. Comfort letters

A comfort letter is a tri-party agreement between the lender, the borrower and the franchisor that typically provides certain lender protections. As franchisors continually revamp these agreements, they seem to provide less comfort to lenders and more hoops to jump through with the franchisor.

Lenders, however, may prefer to get a comfort letter than nothing at all because the comfort letter permits the lender to use the franchise or brand upon a foreclosure. Without the brand, there is no reservation or centralized booking system.

In the heyday of loan originations, comfort letters were not received or fully executed at loan origination. When lenders sold the loans, notice was not provided to the franchisor, thereby invalidating the comfort letter. Because the franchise is a valuable part of the lender’s collateral, lenders typically work to preserve the franchise, and receive notice-and-cure rights and the ability to step into the shoes of the borrower under the franchise agreement upon a foreclosure.

5. Liquor licenses

If a hotel sells alcoholic beverages, lenders will ensure that the liquor license is included as part of the collateral at loan origination. If the license is not held by the borrower, to the extent permitted by local law, the entity holding the liquor license needs to pledge its interest to the lender or cooperate to transfer the license to the lender upon foreclosure.

If permissible in the relevant jurisdiction, a lender will try to get a security interest in the liquor license at loan origination. The majority of the delays to a lender taking title to the hotel in connection with a foreclosure often is related to liquor licensing. If the proper licenses are not received before foreclosure and the liquor-license holder refuses to cooperate, the property will have to go “dry,” depriving the lender of additional revenue, negatively impacting bookings and events, and violating the franchise agreement.

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Commercial mortgage brokers working with hotel properties know they make valuable assets. To ensure that hotel deals fund smoothly, brokers must consider the points that lenders will scrutinize to protect the value of the collateral in a default situation.

Lorelei A. Schumacher is a partner in Bilzin Sumberg’s Real Estate Group, focusing her practice on all aspects of commercial real estate transactions, including acquisitions, development and complex commercial financing involving commercial mortgage-backed securities, participation interests and mezzanine loans. Schumacher has significant experience in the hospitality industry and is active with the servicing, workout and restructuring of distressed hotel loans on a nationwide basis. Reach her at lschumacher@bilzin.com.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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